Monday, January 30, 2012

Freddie Mac's Silly Boo Boo

We are told today that Freddie Mac has some $3.4 billions in derivatives called "inverse floaters" that profit if homeowners do not refinance out of high interest rate mortgages. At the same time that Freddie Mac was accumulating its holdings of inverse floaters, it was tightening requirements for refinancings, thus either wittingly or unwittingly increasing its chances of profiting from its inverse floaters.

The contradiction between Freddie's investment in inverse floaters and its mission of fostering affordable housing for Americans is obvious. Freddie's regulator, the Federal Housing Finance Agency, has been pushing Freddie and Fannie Mae to limit the extent to which they receive taxpayer subsidies. Seeking investment gains has been one way of pursuing that goal. That may be why Freddie took a flyer with the inverse floaters.

While details remain scarce, it appears from news reports that these inverse floaters are interest only strips--investments that paying the holder (Freddie, in this case) the interest payments from a large pool of mortgages. Refinancings of these mortgages mean that interest payments from the pooled mortgages would stop (while interest payments on the new, refinanced mortgages would go to whoever holds the right to those payments, not to the strip). So the more the old mortgages in the pool are refinanced, the greater the likelihood of Freddie losing money on the strip. Inverse floaters are likely to be volatile in value if interest rates change, and probably aren't very liquid because they're risky.

Refinancings increase as interest rates drop. By investing in the inverse floaters, Freddie was in effect speculating on the direction of interest rates. If rates dropped, the inverse floaters would lose money. If rates rose, the inverse floaters could rise in value (although higher mortgage rates would detract from the value of the stream of interest payments, which would be detrimental to the value of the inverse floaters). These inverse floaters may have been a bet on largely stable interest rates.

The silly thing about all this is that Freddie was speculating on the direction of interest rates in volatile investments that would be an embarrassment if the financial press found out about them. After being nationalized in 2008, Freddie should have become greatly sensitized to the need to look good while doing good. These inverse floaters could produce outsized losses if refinancings pick up. Taxpayers might then be called on to provide more subsidies to Freddie, not fewer. And not because Freddie took losses trying to make homes more affordable for America but because it was betting homes wouldn't become more affordable.

It's entirely possible that Freddie's traders have an explanation for the inverse portfolios that sounded pretty good when they talked among themselves. But from a public relations standpoint, the inverse floaters are silly, at best. The true problem is that Freddie and Fannie have too many conflicting goals, attempt to fulfill too many differing expectations, and are simply too big. There are some pretty good arguments that the biggest banks should be broken up into smaller, not too big to fail pieces. All of those arguments apply a fortiori to Freddie and Fannie.

Wednesday, January 25, 2012

Will Hedge Fund Returns Drop?

The last couple of years have seen aggressive enforcement of the insider trading laws by the U.S. Department of Justice and the SEC. The use of wiretap authority has given federal prosecutors a powerful tool not deployed in years past, and greatly amplified investigators' ability to uncover illegal tipping. It seems that, almost every month or two, another hedge fund or traders associated with hedge funds, plead guilty, settle civil charges or both. Entire networks of tipping and insider trading have been blown up.

Traders at surviving hedge funds have no doubt taken notice of the downfall of many of their peers. Those that were dancing at the edge of the curb, or beyond, may well be cooling their jets. Many phone lines on Wall Street are probably less busy these days.

Competitive pressures were doubtless a major reason for hedge funds to engage in insider trading. If a hedge fund that takes 2% of a customer's assets and 20% of gains wants to stay in business, it has to beat the S&P 500 by quite a lot. That's much more easily said than done in the secular bear market that has existed since the stock market downturn in 2000. Inside information offers an edge that can't be beat (as long as you're not caught), and many hedgies just couldn't resist the temptation have a soto voce telephone conversation or twenty-six.

However, explaining lame returns to dissatisfied investors is a lot better than sharing a cell with Bubba. Even if you lose your investors, you don't have to clean latrines used by a lot of other guys. With it likely that many fewer "just between you and me" conversations are taking place on the Street, one must wonder whether hedge fund returns will drop. If you're an accredited investor, or managing money for one, you naturally don't want your money involved in illegality. But you also might ask yourself what returns hedge funds might offer now that federal electronics are policing the markets. A guy who wants 2 and 20 needs to be pretty talented in order to legally make the returns that justify a hedge fund investment, especially with that industry crowded with firms competing for the special profits that economists call "rent" (meaning profits above the level that a competitive market would provide). Think carefully before locking up your money in a hedge fund.

Sunday, January 22, 2012

The Greek Debt Crisis and the Failure of Credit Default Swaps

The Greek debt crisis, from which the entire European sovereign debt morass arises, comes down to a dispute between the Greek government and a group of private investors who hold large amounts of Greek bonds. These investors, many of whom appear to be hedge funds, are refusing to swallow as much loss as the Greek government demands. The Greek government is threatening default. The investors respond by, in essence, saying, "Go ahead. Make my day."

If the Greek government defaults, the investors will turn to credit default swaps they bought to protect against losses on Greek bonds. These CDS's are like insurance coverage against a Greek default. The government wants the investors to "voluntarily" agree to concessions, which wouldn't trigger CDS payouts. The investors have bargained hard, apparently emboldened by the knowledge that they can turn to their insurers if negotiations fail and Greece defaults.

Although usually described as insurance, the CDS's in this instance are being used for speculative purposes. The hedge funds may actually profit more by forcing the Greek government to default, than by working toward a consensual resolution. A default could have severe consequences, triggering a credit crisis in Europe that could circumnavigate the global financial system at the speed of a broadband Internet connection and plaster the world economy with a major credit crunch. Economic dislocation and recession would surely ensue.

When an "insurance" contract turns out to encourage recklessness, it has failed. Insurance is meant to protect against outsized loss, not to encourage insureds to foster or instigate losses. CDS's appear to be motivating speculators to disrupt a nation's finances. That's undesirable, no matter how you look at it.

Regulators and the financial services industry have done little to prevent derivatives, and credit default swaps in particular, from wrecking the financial system, as happened in 2008. Now, derivatives again pose a similar danger. People who don't learn from their mistakes are doomed to make them again. A sense of impending doom is growing.

Thursday, January 5, 2012

The Great Government Risk Transfer

One of the most singular characteristics of government policy since the Great Depression has been to shift financial risks from private hands to the government. Early programs in this respect had broad support because they benefited most citizens. Federal deposit insurance, Social Security and Medicare are notable examples. Other such programs benefited those thought to deserve special protection, such as subsidies for farmers, Aid for Dependent Children, and Medicaid. Fannie Mae, Freddie Mac, Ginnie Mae and HUD were created to boost home ownership, which was believed to promote good citizenship. America, once riven by dissension and social conflict from the sufferings of the Great Depression, stabilized and prospered (helped in part by the fact that it was the one big industrialized nation left standing after WWII). The middle class, in particular, enjoyed the fruits of a life in which many of the vicissitudes of dependency in an industrialized world were lessened. Income inequality shrank and optimism swept away the despair of the Depression.

In the past thirty years or so, the nature of government risk transfers has changed. More recent federal policies have taken financial risks off the hands of the well-to-do and transferred them to taxpayers. Most prominent has been the Federal Reserve's relentless low interest rate program, which boosted the value of risk assets like stocks, bonds and commodities. The Greenspan/Bernanke put--a dramatic lowering of interest rates and expansion of the money supply every time the stock market throws a hissy fit--is now a permanent feature of federal monetary policy. The Fed could not step back from providing, at zero cost to investors, the Grand Put without triggering a horrendous stock market crash. It's no wonder that the rich--whose burgeoning wealth derives mostly from stocks and other risk assets--have gotten richer. With the almighty Fed running interference for them, it's hard for the owners of risk assets not to get wealthier.

Other aspects of federal risk transfer benefitting the wealthy include Fannie Mae, Freddie Mac and HUD, without which the mortgage-backed securities market could not exist. Wall Street banks and financiers are among the biggest beneficiaries of this market. Other familiar examples are the evolution of large-scale farming subsidized by large amounts of farm subsidies and physicians who speed-treat patients to maximize their Medicare billings. Developers and homeowners in flood zones benefit from federal flood insurance, at the expense of taxpayers living on higher ground. Bailout programs like TARP disproportionately benefited the wealthy, while federal mortgage refinance and principal writedown programs that would benefit the unfortunate, have been largely ineffectual.

It's no surprise the wealthy have gotten the most out of federal risk transfers. They control the political process and can steer government policy in their favor. Mitt Romney's narrow victory in the Iowa caucuses only reinforces this trend. Money talks. Those with money have staying power in the political process. The ABM movement in the Republican Party (read Anyone But Mitt) isn't over his wealth, but his moderate views. So if another candidate surpasses Romney in the end and wins the White House, expect the Republicans not to disturb the prosperity of the well-to-do, although those less well-off and retirees should be apprehensive.

The Obama administration, for all its rhetoric, has presented little true threat to the wealthy. It agreed to a moderate temporary version of the estate tax, and has grudgingly gone along with a temporary continuation of the Bush II income tax cuts. Its Treasury Secretary has, overall, been a solid supporter of Wall Street (in spite of occasional politically motivated rhetoric to the contrary). And, despite policy proposals floated to the contrary, Fannie Mae and Freddie Mac continue in their central role financing the U.S. real estate market.

The question is whether this risk transfer can continue. Taxpayers don't have endless resources. Already we have a fierce debate over federal deficits, and there is much talk of imposing more risk on those of moderate and low income (by reducing Social Security, Medicare and Medicaid benefits). In Europe, we see the makings of a taxpayer revolt, with those in southern Europe objecting to paying more to cover the profligacy of their governments while those in northern Europe object to paying more to cover the profligacy of their southern neighbors.

American taxpayers haven't really honed in on the Great Government Risk Transfer in the U.S., even though it underlies many of today's political controversies. If the costs of such risk transfers continue to mushroom, citizens will eventually figure out that their pockets are being picked. If we truly believe in a market-based economy, governed by the principles of free markets, we have to cut back on the government's risk transfers, especially the ones benefiting the wealthy. Those who have capital to invest can do the most for society if they invest in ways undistorted by government subsidies. As things stand now, the wealthy have the incentive to profit off of taxpayers. It's fine if someone works hard, saves, invests wisely and gets rich. It's not fine if someone pigs out at the public trough. Income inequality honesty earned is deserved. Income inequality fostered and supported by government policy is unacceptable.